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If your company plans to borrow funds: check the tax implications

20 August 2002

Our tax system encourages New Zealand taxpayers to obtain debt funding rather than equity funding. This is because tax deductions are allowed for interest and this, in turn, reduces the New Zealand taxpayer’s taxable income. Deductions, however, are not allowed on the payment of dividends. In this article, we discuss your withholding tax obligations and ways in which you can make it more tax-efficient for lenders to lend to your business.

The choice of whether you borrow from a New Zealand resident or a non-resident lender is likely to be determined by commercial, rather than tax, considerations. However, tax is likely to figure in your decision and it is particularly important that you are aware of your withholding tax obligations or you may be subject to penalties under the Tax Administration Act 1994. Offshore debt financing is particularly sensitive to tax costs. This is because lenders can shift their funding to another country with lower tax rates on interest with relative ease. As the borrower, if you obtain debt financing from offshore you are likely to have obligations to withhold New Zealand tax for any interest you pay to the non-resident lender.

Non-resident withholding tax on interest

Interest paid to an offshore lender is subject to non-resident withholding tax (NRWT). The rate of NRWT on interest is currently 15% but this may be reduced to 10% under most of New Zealand’s double tax agreements.

Importantly, some of New Zealand’s double tax agreements do not reduce NRWT on interest to 10% when the interest is paid between associated persons. Also, NRWT on interest paid between associates is not a final tax for domestic law purposes, meaning that the lender may have further New Zealand tax to pay on the interest derived by it.

Interest for NRWT purposes is defined very widely. Interest effectively includes every payment received by a lender in respect of money lent, excluding the original principal. Interest includes any premium received by the lender for making a loan and a redemption payment (being the discount from face value) in respect of a commercial bill. Certain types of quasi-debt instruments such as finance leases also give rise to deemed interest for tax purposes.

A New Zealand resident who pays interest to a non-resident is obliged to deduct NRWT and pay it to the IRD. That obligation is triggered when interest is paid. Once interest is paid, NRWT must generally be accounted for to the IRD by the 20th of the following month. “Pay” and “paid” are widely defined and include crediting to an account or dealing with on behalf of the lender. So, a NRWT obligation will be triggered where interest is compounding because the interest is credited to the lender’s account as it compounds. This treatment of compounding interest can sometimes create difficulties in specifying the correct amount to be credited to the lender.

Approved issuer levy

Instead of paying NRWT at 10% or 15%, you may instead be able to pay a 2% levy under the approved issuer levy (AIL) regime. The AIL regime requires the approved issuer (i.e. the borrower) to pay a levy of 2% of the interest for the right to pay that interest at a zero rate of NRWT.

AIL was introduced to reduce some of the costs incurred by New Zealand residents when they borrow from non-resident investors who are either unwilling or unable to bear the costs of having NRWT deducted from their interest income. Such non-resident investors typically required the New Zealand borrower to “gross up” the interest paid by the amount of any NRWT. This tended to increase domestic interest rates.

There are two main situations where you are not eligible to use the AIL regime. The first is where the lender and borrower are associated for income tax purposes. Consequently, for a non-resident parent company looking to fund its New Zealand subsidiary, NRWT is likely to be an added cost of funding unless a tax credit can be obtained for the NRWT in the parent company’s country of residence. A more tax-efficient result may be achieved if the subsidiary borrows from a third party rather than its non-resident parent, with the parent company guaranteeing the subsidiary’s obligations if necessary.

The second situation where the AIL regime cannot apply is more unusual. AIL does not apply where two or more persons are jointly entitled to the interest and at least one is a New Zealand tax resident. This second exclusion is primarily aimed at holders of joint bank accounts where one of the joint account holders is a resident and the other is a non-resident. In these circumstances, NRWT applies to the non-resident at the same resident withholding tax (RWT) rate that applies to the resident.

Approved issuer status

If you decide to use the AIL regime instead of paying NRWT, you must apply to the Commissioner of Inland Revenue to obtain approved issuer status. If you do not initially register for AIL and decide later that you would like AIL to apply, any interest you pay before you register the security (i.e. the loan or other transaction) will be subject to NRWT at the standard rate. So, it is important that you register the security as soon as possible. Also, any late payment of AIL will be subject to a late payment penalty, use of money interest and, possibly, shortfall penalties. If you are late in making an AIL payment, you are not liable for NRWT by default.

Who bears the AIL cost?

Whether the borrower or the lender bears the cost of the 2% levy is for the parties to decide. If the cost of the AIL is borne by the lender, it should be treated as a fee or a charge imposed on the lender because it is a levy rather than a tax.

Although the rate of AIL is considerably less than the rate of NRWT on interest, some lenders may, if they are required to bear the AIL cost, still prefer to have NRWT deducted from their interest income rather than AIL. NRWT may be more advantageous to a non-resident lender than AIL if the lender is able to obtain a tax credit for the NRWT paid. Tax credits cannot generally be obtained for AIL in overseas jurisdictions because AIL is not a tax.

Even if a credit for foreign tax is available in the lender’s country of residence, NRWT may still be an after-tax cost to the non-resident lender if the tax rate in the lender’s country is lower than the rate of NRWT. In this situation, the non-resident lender may obtain more foreign tax credits than it can use and NRWT would be a cost to it to the extent of the excess foreign tax credits. Also, it is fairly common for non-resident lenders to be reluctant to seek a foreign tax credit in their country of residence, even if they are entitled to it, because of delays that may be associated with obtaining that credit.

Structures where no AIL/NRWT is payable

Branch structures

Depending on your circumstances, you may be able to borrow offshore without having to pay AIL or NRWT on the interest paid to the non-resident lender. One method of achieving this result is by using an offshore branch. Under the Income Tax Act 2007, interest paid by a New Zealand resident is not taxed in New Zealand (because it does not have a New Zealand source) if:

  • the interest is in respect of money lent outside New Zealand, and
  • the money lent is used by that New Zealand resident to do business through a fixed establishment which is outside New Zealand.

Not every offshore presence will qualify as a fixed establishment for tax purposes. A fixed establishment is defined in the Income Tax Act 2007 as a fixed place of business in which substantial business is carried on. Our experience is that the IRD takes quite a restrictive view as to what constitutes a substantial business and it generally likes to see staff and physical activities being undertaken out of the branch. Simply owning land or a building, for example, is unlikely to be enough without some business activities being carried on through that property by the owner.

We recommend being cautious in the area of offshore branches as the IRD may regard offshore branch structures as avoidance of NRWT in some circumstances. For example, if the branch was established simply to avoid NRWT and there is no real or substantial business carried on by the branch, the anti-avoidance rules in the Income Tax Act 2007 may apply. In many situations, however, we believe that offshore branches can legitimately remove or reduce NRWT or AIL obligations without there being any tax avoidance.

Borrowing from a New Zealand resident

The alternative to borrowing from offshore is, of course, to borrow from a lender that is tax resident in New Zealand. Interest that you pay to the resident lender will be subject to RWT at the applicable rate unless that lender holds a certificate of exemption from RWT, or another exemption applies. The rate of RWT on interest applying to companies is usually 33%. For individuals, the RWT rate is either 19.5%, 33% or 39%. The rate depends on whether the individual has provided his or her IRD number to the payer of the interest and whether he or she has elected to have RWT deducted from their interest income at one of those rates.

There are a number of ways a person may qualify for a certificate of exemption. Most large companies can obtain an RWT certificate of exemption from the IRD on the basis that their annual gross income exceeds $2 million or because they have reasonable grounds for believing that their annual gross income for the next accounting year will be more than $2 million.

The IRD requires borrowers to take reasonable steps to ensure that certificates of exemption held by persons to whom they pay interest are valid. The IRD requires that a borrower check that any certificate provided to it has not expired. Although the holder of a certificate is obliged to inform affected persons if their certificate is cancelled, the IRD also requires that the payer of the interest has procedures in place to check that a certificate of exemption has not been cancelled by the Commissioner. Cancellations are published in the New Zealand Gazette.

Other tax issues

There are other tax issues you need to think about when obtaining debt funding for your business.

Interest deductions

One of the most important is ensuring you can obtain a tax deduction for your interest costs. For most companies, automatic deductions (from the 1997-98 income year) is allowed. This automatic deduction for interest is not available to individuals, partnerships, trusts or the following types of companies:

  • a qualifying company
  • a company that derives only exempt income, or is a member of a group of companies where one or more derives exempt income (unless the exempt income is dividend income, or exempt income from the cancellation of treasury stock, or certain exempt income from an animal breeding business) a non-resident company (except to the extent the company incurs the interest in the course of carrying on business through a fixed establishment in New Zealand).

If you do not qualify for the automatic interest deduction, you will need to show a link between the interest expense and the process of earning gross income or carrying on a business to derive gross income. This is broadly the same deductibility test that you must satisfy to obtain deductions for other expenses besides interest.

Thin capitalisation

You should also ensure that deductions for your interest costs are not restricted under the thin capitalisation rules. These rules potentially apply to non-residents (other than companies controlled by New Zealand residents), resident companies controlled by non-residents, and non-qualifying trusts with a non-resident settlor. If your business is one of these entities, its interest deductions could be restricted if its debt levels exceed certain levels in the thin capitalisation rules.

Transfer pricing

Another way your interest deductions could be limited is under the transfer pricing rules. If interest is paid on cross-border debt and that debt arises with an associated company, it is important that the interest is set at “arm’s length” rates or it may be adjusted by the Commissioner of Inland Revenue. The consequence of any such adjustment could be that your interest deductions are reduced and, in addition, penalties and use of money interest may apply.

Going forward, we believe it is important that New Zealand tax rates on interest are in line with the tax rates of our competitors. Of note, Australia has renegotiated its double tax agreement with the United States so that no tax is chargeable on interest paid from an Australian borrower to a United States lender if the interest is derived by a US resident financial institution (subject to certain safeguards). Further afield, the double tax agreement between United Kingdom and the United States (agreed to last year) provides that there is no withholding tax on most interest payments made between US and UK residents. Whether New Zealand is able to negotiate similar concessions in its double tax agreement with these countries remains to be seen.

A checklist for borrowers

For AIL to apply:

  • the lender must not be associated with you
  • the lender must not be a non-resident that derives the interest jointly with a person who is resident in New Zealand for tax purposes
  • you should agree with the lender as to who is to bear the AIL cost – if the lender is to bear it, deduct the levy from the interest as a cost or charge, not as a tax
  • you must register as an approved issuer paying interest on a registered security
  • you or the lender must pay AIL by the due date, usually the 20th of the month following payment of the interest (accompanied by a completed IR 67A). NRWT obligations (if AIL does not apply or has not been elected)
  • determine the correct NRWT rate (i.e. does a double tax agreement apply to reduce the NRWT rate?), and
  • deduct NRWT from interest when interest is paid (paid includes credited).

RWT obligations

  • Deduct RWT from interest when the interest is paid
  • Has the lender provided you with a certificate of exemption? Have you checked the New Zealand Gazette to see if it has been cancelled?
  • Determine the correct RWT rate - 19.5%, 33% or 39% (depending on whether the person is a company, has elected one of these rates, and whether the person has provided you with their IRD number).

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